Depreciation is the reduction in the value of an asset over time due to wear and tear, obsolescence, or other factors.
Generally, the term ‘depreciation’ denotes a decrease in value, but in accounting, this term denotes a decrease in the book value of a fixed asset.
Because fixed assets are used to create periodic income, an appropriate percentage of the cost of fixed assets that are thought to be utilised or expired to generate periodic revenue must be charged as a cost. Depreciation is the term used to describe this proportion of the cost of fixed assets.
Depreciation is the permanent and continuous decrease in the book value of a fixed asset due to use, effluxion of time, obsolescence, expiration of legal rights or any other cause.
Definition of Depreciation
According to the Institute of Chartered Accountants in England and Wales, ‘Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned.’
Depreciation is not the result of fluctuations in the value of fixed assets since the fluctuation is concerned with the market price of the fixed asset. In contrast, depreciation is concerned with the historical cost.
An analysis of the definition given above highlights the characteristics of depreciation as follows:
- It is related to Depreciable fixed assets only.
- It is a fall in the book value of a depreciable fixed investment.
- The fall in the book value of an asset is due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause.
- It is a permanent decrease in the book value of an asset.
- It is a continuous decrease in the book value of an asset.
Comprehensively, the term ‘Depreciation’ covers Depletion, Amortization and Obsolescence.
The term ‘Depletion’ refers to the physical deterioration by the exhaustion of natural resources (ore deposits in mines, oil wells, quarries, timber stands etc.).
The term ‘Amortisation’ refers to the economic deterioration by the expiration of intangible assets (patents, copyrights, goodwill etc.).
The term ‘Obsolescence’ refers to the economic deterioration by
(a) the invention of improved techniques or equipment
(b) market decline due to changes in taste and fashion etc.
(c) inadequacy of existing plants to meet the increased business.
Accounting Treatment of Depreciation
The depreciation is charged against the Profit and Loss Account profits in accounting. In another sense, the amount of depreciation is debited to the Profit and Loss Account, and the amount of profit is reduced to the extent of depreciation. There are several methods of computing depreciation that vary from business to business and according to the nature of the industry.
Depreciation can be calculated using various methods, including straight-line depreciation, declining balance depreciation, and sum-of-the-years-digits depreciation. The method used will depend on the asset’s nature and the business’s accounting policies.
Examples of Depreciation Calculation
Let’s say a company purchases a new computer system for $10,000. The company expects the computer system to have a useful life of 5 years and a salvage value of $2,000 at the end of its useful life.
Using the straight-line depreciation method, the annual depreciation charge would be:
($10,000 – $2,000) / 5 = $1,600 per year
So the company would record a depreciation expense of $1,600 yearly for the next 5 years.
Here’s an example calculation of declining balance depreciation:
Let’s say a company purchases a machine for $50,000. The company expects the machine to have a useful life of 8 years and a salvage value of $2,000 at the end of its useful life. The company decides to use a depreciation rate of 20% per year for the declining balance method.
The annual depreciation charge for each year is calculated as follows:
Year 1: $50,000 x 20% = $10,000 Year 2: ($50,000 – $10,000) x 20% = $8,000 Year 3: ($40,000 – $8,000) x 20% = $6,400 Year 4: ($31,200 – $6,400) x 20% = $4,960 Year 5: ($24,760 – $4,960) x 20% = $3,772 Year 6: ($20,788 – $3,772) x 20% = $3,403.60 Year 7: ($17,014.40 – $3,403.60) x 20% = $2,522.72 Year 8: ($14,610.72 – $2,522.72) x 20% = $2,177.40
So the company would record a depreciation expense of $10,000 in year 1, $8,000 in year 2, $6,400 in year 3, and so on until year 8.
What is the Need for Accounting for Depreciation?
Matching of Cost and Revenue – The assets such as equipment and machinery, furnishings etc., are used in the firm to earn income. So, the erosion of such assets due to use and wear ought to be viewed as a commercial loss. In order to determine the actual profit or loss, it should be charged to the profit and loss account just like any other corporate expense.
Taxation Purpose – Depreciation is a tax-deductible expense. Accounting for depreciation helps companies minimise the tax burden. Otherwise, they will be paying higher tax on profits.
True and fair financial position – When assets lose value due to depreciation, fixed assets should be represented in the balance sheet at their book value to reflect the company’s financial situation accurately.